Selling a BusinessA Guide for Angel Investors

and Entrepreneurs

Keynote Speech at the National Angel Capital Organization Summit

Toronto, OntarioOctober 15, 2009

Basil Peters

Qualifiers on This Presentation

• I was a technology entrepreneur

• And now I am a technology investor

• My comments are from that perspective

• Some aspects of financing and exit strategies are different for life science and clean tech companies

• I am not including ‘public market’ strategies (until those markets recover)

Angel Investing is Still New

• Organized angel investing is still quite new

• The early angel groups started around 1997

• Angel investing today is where traditional Venture Capital was in the early 1980s

• We are still discovering the best practices

• The financial world is also changing – a lot

• That’s why these meetings are so valuable

Perspective On My Comments

• I am a geek

• PhD in Electrical and Computer Engineering from the University of British Columbia

• Started my first company at grad school

• Nexus grew to be the world’s 2nd largest manufacturer of cable TV headends

• Sold in 1993 to Scientific Atlanta – nowpart of Cisco

My Tech Investment Funds

• When we sold Nexus, it was the first timeI had money to invest

• Been an enthusiastic tech investor since

• Founded and managed a:

• Hedge fund – 1996 to 2000

• Venture Capital Seed fund – 2002 to 2006

• Angel fund – 2005 to present

What I’ve Learned About Investing

• I’ve learned (expensively) that successful investing requires two things:

• Buying right – investing in the right opportunities using the right structures, and

• Exiting well – getting my money back at a good price and in a reasonable time frame

• This talk is about M&A exits

How I Got Started on Early Exits

• I became fascinated by early exits in 2002

• When starting a Venture Capital seed fund

• The B.C. government provides a 30% tax credit to investors in qualified VC funds

• But under that legislation, the investors can get their money back in just five years

• Less than half the time for typical VC funds

Building a “5 Year” VC Fund

• As a fund manager, I knew I would need to focus intently on exits

• To provide liquidity in just 5 years

• I managed the BC Tech Fund for 3 years

• During that period, I made 9 investments

• Had three exits – 2 acquisitions and an IPO

• #1 Canadian VC tech fund of that vintage

Early Exits Increase Returns

• The success of the BC Tech Fund taught me that:– Early exits can be designed into the

corporate DNA and investment term sheet– Early exits increase investment returns– Early exits work for entrepreneurs and

angel investors (but maybe not VCs)– Early exits are fun

Early Exits – The Book• Started to share some

of what I had learned about exits on my blog:www.AngelBlog.net

• That grew to be an entire book

• Available in hard cover or ebook formats at: www.Early-Exits.com

Earlier Talks on Exit Strategy

• Online videos of my recent talks on exits:• www.angelblog.net/

Exit_Strategies_for_Angel_Investors_Video.html

• www.angelblog.net/Start_at_the_End_Your_Exit_Strategy.html

• And what not to do:

• www.angelblog.net/Dont_Blow_the_Biggest_Deal_of_Your_Life.html

From Strategy to Execution

• Recently, I’ve had a number of requests to ‘go to the next level’ and talk about exit execution

• This presentation is a practical guide on“How to Sell a Business”

• For Angel investors and entrepreneurs (but maybe not traditional Venture Capitalists)

Increasing The Number of Exits

• We can all increase our successful exits by:

• Focusing on exits before we invest

• Helping entrepreneurs build alignment on the exit strategy (also before we invest)

• Designing our term sheets to facilitate the exit transaction - especially vesting

• Really understanding VC follow-ons

Exits Without and With VCs

Without VCs

With VCs

Why ? Pleasewatch my videosor read my book

Angel or VC ChecklistAngels VCs

Amount of capital required to prove the business model

Under $5 – 10 million Over $5 – 10 million

Years before being able to exit

2 to 5 years Over 10 to 12 years

Most likely value of the company at the time of the optimum exit

Under $50 million Over $100 million

Willingness to relinquish control of important financial decisions

Not always required Almost always required

Focusing on Exits is Healthy

• Companies can be pre-selected for exit suitability – depending on your criteria

• It is surprising how often entrepreneurs will ask for investment in ‘life style’ or ‘no exit’ companies

• A focus on exits is healthy - and in my strong opinion, does not detract the team from their primary function of maximizing shareholder value (a popular myth)

Companies Are Sold, Not Bought

• I often hear ‘companies are bought, not sold’

• People think that when ‘it’s time’, someone will knock on their door to buy their company

• While that has happened, it’s almost never a good thing for the shareholders

• It’s not just that the price will be much lower

• More importantly, the probability of success decreases because there is only one bidder

Building Shareholder Value

0

10

20

30

40

50

60

70

80

90

100

Founders startcompany

Develop productand make the

first sale

Founding = 10% Equal Tactics & Strategy = 40% Exit Strategy & Execution = 50%

Mentors assistcompany during

periods of growth

But Mentorsadd much

higher value at inflection points

Exit strategy, find buyer,structure, negotiateand close transaction

A well designed and executed exit

can create as much value as all of the other work.

Time

Shar

ehol

der V

alue

Steps to Completing an Exit• The basic steps to completing an exit are:

1. Build alignment on a realistic exit strategy2. Engage the best professionals3. Clean up the corporate structure4. Prepare for due diligence5. Do a secondary sale (in some cases)6. Build the sales funnel7. Manage the auction (multiple bidders)8. Negotiate and close

The Exit Is Just Another Process

• Whether it’s a financing, product development, marketing or sales goal

• The chances of success increase dramatically if you have a good plan

• Your exit strategy is the plan for your business – the entire business

• Your plan should start at the end (the goal)

• Every company needs an exit strategy

The Exit Strategy

• An Exit Strategy can be as simple as:

• “Our exit strategy is to [sell the company] in about __ years for around $ __ million.

• We plan to execute the exit by engaging a [mid market M&A advisor] by _[date]_.”

• The optimum exit strategy depends on the type of company

• Entrepreneurs need help on this

Term Sheets to Facilitate Exits

• There are several elements of the term sheet that confirm the ‘exit intention’ and

• Reduce ‘exit friction’

• The Articles should specify that a 51% vote of all shares can effect a sale (a drag along)

• Vesting is the most powerful term

• “Puts” and redemptions are popular inVC term sheets but are rarely effective

Vesting to Maintain Exit Alignment

• All stock options, and all nominally priced previously issued shares, should vest on the following basis:

• 50% of the shares vest daily and linearly over a three year period; and

• The other 50% vest on a sale of the business

• All vesting accelerates on a sale

Who are the Buyers Today?

• The most familiar buyers are Fortune 500 companies

• But medium sized companies are also aggressive buyers – especially public ones

• Private Equity funds are also coming back into the market now that debt is available

• Also individuals who are too young to retire

Start Right After The Financing

• Big companies are spending more on M&A than R&D –it’s the best way for them to grow

• Big companies are VCs fiercest competitors

• Tech companies are now regularly acquired just two or three years from start up

• Which means that management should start to work on the exit right after the last angel round closes

How Early Can You Sell?

• A common misunderstanding about M&A exits is that you have to grow the company to be profitable

• Or grow it to be larger than $X millions of revenue

• The real threshold is to ‘prove the business model’

What it Means to Prove the Model

• In a recurring revenue business, for example, you have a spreadsheet that clearly shows actual results for:1. Gross margin per customer2. Customer lifetime (or churn)3. Cost of customer acquisition

• In other words, how much is a customer worth and what do they cost to acquire?

Proven Model and Value

• Some businesses have slightly different metrics to prove the model

• But when you prove the model you can build a credible projection that shows if:1. New owners added $X millions of capital,2. The business would have Y customers 3. And be worth $Z millions

• Then you can successfully sell the business

It’s Often The Optimum Time

• As soon as you prove the model is often the best time to sell

• Always better to sell on an upward trend

• Sell on the promise not the reality

• Often when you can get the best price

• Very often ‘stuff happens’

• Most entrepreneurs wait too long to start

Don’t ‘Ride It Over The Top’

• It’s human nature not to think about exiting when everything is going well

• We often wait to start the exit process once it is clear that the value has peaked

• And by the time the buyers are serious, it’s obvious to everyone

• I did that - and recently told the story in “Don’t Blow the Biggest Deal of Your Life”

Exits Are Not Well Understood

• Exits are the least understood part of being an entrepreneur or Angel

• Not surprising because it doesn’t happen very often

• From Scott Shane, author of Fools Gold:– 1 to 1.5% of Angel backed companies exit– 5.9% of Angel group deals exited in 2008

• (Not yet clear if this is a trend)

Why The CEO Should Not Lead

• There are several reasons the CEO should not lead the exit process, they:– Rarely have the exit experience– Need to maximize the financial results– Should be held in reserve for the final

negotiation of price and terms– Are often conflicted– Need a good relationship with the new

owners (cannot be the ‘bad guy’)

The Ideal Exit Team

• Almost every company needs a team dedicated to maximizing the price and ensuring the transaction completes

• The ideal exit team is:– The CEO – An M&A Advisor– Possibly an Exit Coach– A small committee of the board

The Exit Coach – A New Idea

• In the old, VC dominated, model CEOs and boards were less involved with the exit

• Very few directors, and fewer CEOs, have a lot of exit experience

• Often ‘new’ companies should start on the exit just a year, or two, after start up

• Exit knowledge and experience is even more critical for these young companies

The Exit Coach

• This new environment has created a need for a new type of professional with the same depth of knowledge as an M&A advisor,

• Engaged on a financial model more typical of a ‘coach’ ($0.5 to 2k /month)

• To work with the CEO before the company engages a full M&A advisor

• And to help select the M&A advisor

Selecting The M&A Advisor

• There is almost nothing written about selecting M&A advisors

• The majority make sub-optimum choices

• Relationships are always exclusive

• The most important criteria are:– Transaction completion rate– Track record of maximizing price– Proximity, knowledge and compatibility

The M&A Advisors Function

• The M&A advisor is really ‘the sales guy’

• Their important functions are to:– Plan and coordinate the process– Reduce the time to closing– Improve the probability of success– Protect the CEO (for as long as possible)– Maximize the price and terms– Do the selling and be the ‘bad guy’

M&A Advisory Fees

• Fees for selling companies are not published but are surprisingly uniform

• Work fees usually $50,000 regardless of the company size (less if learning or not busy)

• Success fee, including the work fee, from:– 7 to 10% for sales under $5 million– 4 to 6% for sales from $10 to 30 million– 2 to 3% in the $100 million range

M&A Advisors Should Be Local

• CEOs and boards often start to look for an M&A advisor in the big financial centers

• Dirty secret is that about a third of M&A engagements fail to complete a transaction

• And the failure rate increases as the distance to the M&A advisor increases

• An M&A advisor relationship is intimate and intense – it requires a lot of face time

M&A Advisors Should Be Local

• For the last third of the process, the M&A advisor will almost live with the company

• Some firms say they can do this remotely

• But for transactions under $100 million, the fees are not enough for the travel required

• Local M&A advisors will also work much harder to protect their reputations

• And are easier to do due diligence on

Do a Secondary Sale

• A secondary sale is where new investors buy founders’ and early investors’ shares

• A secondary share sale can be almost ‘magical’ in finalizing alignment and solving structural defects

• Considered almost impossible a decade ago

• Today, secondary are much easier to do

The Exit Timeline

• Once an M&A advisor has been engaged

• The exit usually takes 6 to 18 months

• Depends mostly on the company

• Most of the time is spent preparing the due diligence and sales collateral

• The next biggest time sink is scheduling

• Then waiting for lawyers

Before Contacting Buyers

• A common, and expensive, mistake is engaging with prospective buyers before the company is ready

• Then realizing that there is a lot to be done before due diligence can complete

• At worst, the buyer loses interest

• At best, it costs the company hundreds of thousands in professional fees

Clean Up The Structure

• In almost every exit I have seen

• There are structural defects that need to be cleaned up before the exit can complete

• Some are built into the corporate structure

• Others are contracts with unforeseen consequences during an exit

• Fix these before contacting buyers

Employment and IP Agreements

• Do the deep patent work early

• Every buyer will want senior and technical employees to have signed a good, modern employment agreement

• Many companies miss the contractors

• Both are essential for IP ownership

• Don’t get held for ransom at the closing by an employee who doesn’t want to sign

Corporate Records and Taxes

• Have a very experienced M&A lawyer review all of the corporate records early

• Shareholder and board meeting minutes are critical

• Taxes are different in each state and can be almost impossible to get certainty on

• Don’t overpay your law firm to build the corporate record history at the last minute

The Shares and Share Register

• About half of the companies I’ve seen start an exit don’t have their shares properly issued or properly recorded

• Far too often the sale proceeds will be in the lawyers trust account before shareholders start to dispute the records

• And print out years old emails from the CEO

• Get everyone to sign confirmations early

Review or Audited Financials

• Most companies have notice to reader financial statements

• Post Enron, audit costs have skyrocketed

• Some buyers will accept review engagements, but others need audits

• Consider reporting in US currency

• Don’t pay your outside accountants double at the end to do the review or audit

The Sales Collateral

• Should all be complete before contacting the first prospects:– Complete due diligence online– Teaser document (2 pages)– Selling document (20 pages)– Financial history and projections (Excel)– PowerPoint for online and boardroom

presentations

The Sales Funnel

• For most companies, the suspect list can be 50 to 100 buyers

• 10 to 20 might sign the NDA and get the selling document and financials

• 5 to 7 might visit and start due diligence

• Optimum short list is 3

• And is probably a practical maximum

Maximizing Exit Value

• There are several ways to maximize the final selling price:1. Structural value increase2. Illuminating strategic value3. Capitalizing on Inefficient Markets4. Maintaining multiple bidders5. Sales and negotiating skill

Structural Value Increase

• Often small tweaks in the corporate structure can increase the final selling price by 10 to 15%– These can be balance sheet changes– Asset vs. share sales– Financing mechanisms like sub debt– Tax innovations

• Opportunities are almost endless but can often add $ millions

Illuminating Strategic Value

• Identifying strategic value often creates the largest fundamental increase in selling price

• It’s not actually creating strategic value, it usually has to be there already

• But it very often has to be illuminated for the potential buyers (often very challenging)

• This can often be the most valuable contribution from the M&A professional

Capitalizing on Inefficient Markets

• Markets for selling a business, especially for under $100 million, are very inefficient:– Information is difficult to access– There are a small number of buyers– The market is illiquid– Often very few for sale (like yours)

• All of which can be big advantages for the seller

Benefits of Multiple Bidders

• An unsolicited offer is almost always a lost opportunity

• Every business sale should have multiple bidders to:– Increase the final selling price– Increase the probability of completion– Close the transaction sooner– Demonstrate good governance

Selling and Negotiating Skill

• There is no question that some sales people are just better – often much better

• Selling a company is just like any other sale – but bigger and more complex

• A really outstanding M&A advisor can help to increase the final price by 50% or more

The Reps and Warranties

• A very experienced M&A lawyer friendsays that in his experience,

• More M&A transactions fall apart on the Reps and Warranties than price and terms

• CEOs, and Directors, should be afraid to sign personal guarantees about things that are literally unknowable

• But they have to – so introduce it early

Closing and The Party

• Once everything is completely agreed to

• It still takes forever to close (4 to 8 weeks)

• There are hundreds of small sticking points

• And fate will have it that their lawyer is working on three closings simultaneously

• M&A closing parties are always the best parties (that I am allowed to go to)

Exits and Recycling

• I think exits are the best part of being an entrepreneur and investor

• It’s when we get paid for all of our hard work and risk capital

• It’s also when entrepreneurs and angels have the option of doing it all again,

• Or doing something else with our money

• Think of it as recycling.

Resources

• www.Early-Exits.com – my book on exit strategies for angels and entrepreneurs

• www.AngelBlog.net – my blog for entrepreneurs and angel investors

• www.BasilPeters.com – for a video of this and some of my previous talks

Good Luck WithAll of Your Exits!